Economics Theme 1 Key Definitions

Ceteris Paribus

All things being equal; the assumption that, whilst the effects of a change in one variable are being investigated, all other variables are kept constant

Normative Statement

A statement which cannot be supported or refuted because it is a value judgment e.g. “should be”

Positive Statement

A statement which can be supported or refuted by evidence (includes fact)

Scientific Method

A method which subjects theories or hypotheses to falsification by empirical evidence

Theory or Model

A hypothesis which is capable of refutation by empirical evidence

Factors of Production

The inputs to the production process; land, labour, capital and enterprise/entrepreneurship

Land

As a factor of production = all natural resources

Labour

As a factor of production = the workforce

Capital

As a factor of production = stock of manufactures resources used in the production of goods and services

Enterprise or Entrepreneurship

As a factor of production = the seeking out of profitable opportunities for production and taking risks in attempting to exploit these

Basic Economic Problem

Resources have to be allocated between competing uses because wants are infinite whilst resources are scarce

Scarcity

Arises when people have unlimited wants & limited resources

Wants

Desires for the consumption of goods and services

Needs

The minimum that is necessary for a person to survive as a human being

Renewable Resources

Natural resources that can be replenished (won’t run out) e.g. solar energy

Non-renewable Resources

Natural resources that once used, cannot be replenished (will run out) e.g. coal or oil

Opportunity Cost

The value of the next best alternative

Economic Goods

Goods that are scarce because their use has an opportunity cost

Free Goods

Goods that are unlimited in supply and therefore have no opportunity cost

Capital Goods

Goods that are used in the production of other goods such as factories, offices, roads, machines and equipment

Consumer Goods

Goods and services that are used by people to satisfy their needs and wants

Production Possibility Frontier (PPF)

A curve showing maximum combinations of goods and services that can be produced in an economy in a given time period if all resources are fully and efficiently employed

Market

Any convenient set of arrangements by which buyers and sellers communicate to exchange goods and services

Money

Any item, such a coin or a bank balance, which fulfils four functions; a medium of exchange, a measure of value, a store of value and a method of deferred payment

Public Sector

The part of the economy where production is organized by the state or the government

Private Sector

The part of the economy owned by individuals

Primary Sector

Extractive and agricultural industries

Secondary Sector

Industries involved in the production of goods, mainly manufactured goods

Tertiary Sector

Industries involved in the production of services

Division of Labour

Specialisation by workers, who perform different tasks at different stages of production to make a good or service, in cooperation with other workers

Productivity

Output per unit of input

Market Economy

An economy in which market forces are allowed to guide the allocation of resources

Command Economy

An economy in which decisions on resource allocation are guided by the state

Mixed Economy

An economy where resources are partly allocated through price signals and partly through state intervention (command & free market)

Microeconomics

The study of the behaviour of individuals/groups such as consumers, firms or workers, typically within a market context

Macroeconomics

The study of the economy as a whole (on an aggregate level), including inflation, growth and unemployment

Demand

Quantity of a good or service that consumers are willing and able to buy at a given price at a particular time

Law of Demand

States that an increase in price will initiate a fall in demand & a fall in price will initiate a rise in demand (ceteris paribus)

Law of Diminishing Marginal Utility

Describes the situation where an individual gains less additional utility from consuming a product as more of it is consumed

Consumer Surplus

The difference between how much buyers are willing to pay for a good and how much they actually pay (total savings to consumers who are willing to spend more than the equilibrium price)

Elastic

Responsive to price changes

Inelastic

Not responsive to price changes

Price Elasticity of Demand (PED)

Percentage change in quantity demanded ÷ percentage change in price (ALWAYS NEGATIVE)

Cross Price Elasticity of Demand (XED)

Percentage change in quantity demanded of good X ÷ percentage change in price of good Y

Substitutes

A good which can be replaced by another to satisfy a want – they have a positive cross elasticity of demand with each other. E.g. Pepsi & Coke

Complements

A good that is purchased with other goods to satisfy a want - they have a negative cross elasticity of demand with each other. E.g. Cinema tickets & Popcorn

Income Elasticity of Demand (YED)

Percentage change in quantity demanded ÷ percentage change in income

Normal Good

A good where demand increases when income increases

Inferior Good

A good where demand falls when income increases e.g. supermarket own brands

Luxury Good

A good where demand rises as income rises e.g. air travel

Necessity

A good where a change in income does not affect demand e.g. toilet paper

Supply

The quantity of goods that supplies are willing to sell at any given price over a period of time

Producer Surplus

The difference between the market price which firms receive and the price at which they are prepared to supply

Price Elasticity of Supply

Percentage change in quantity supplied ÷ percentage change in price

Equilibrium Price

The price at which there is no tendency to change because planned purchases (demand) are equal to planned sales (supply)

Free Market Forces

Forces in free markets which act to reduce prices when there is excess supply and raises prices when there is excess demand

Incentive Function (price mechanism)

When changes in price encourage buyers and sellers to change the quantity they buy and sell. A rise in price encourages buyers to purchase less and sellers to produce more, vice versa.

Rationing Function (price mechanism)

When changes in price lead to more or less being produced, so increasing or limiting the quantity demanded by buyers

Signalling Function (price mechanism)

When changes in price give information to buyers and sellers which influence their decisions to buy and sell

Merit Good

A good that brings unanticipated benefits to consumers e.g. education

Demerit Good

A good that brings unanticipated costs to consumers e.g. tobacco

Incidence of Tax

The tax burden on the taxpayer

Ad Valorem Tax

Tax levied as a percentage of the value of the good e.g. VAT

Specific/Unit Tax

Tax levied on volume

Subsidy

A grant given by government to lower the price of a good, usually designed to encourage production and consumption of merit goods

Market Failure

When resources are inefficiently allocated due to imperfections in the working of the market mechanism

Externality

A cost or benefit that is external to a market transaction and is not reflected in market prices – bourne by third parties

Positive Externality

When social benefits > private benefits

Negative Externality

When social costs > private costs

Marginal

Social and Private Costs and Benefits

Private Cost and Benefit

The cost or benefit of an activity to an individual economic unit such as a consumer or firm

Social Cost and Benefit

The cost or benefit of an activity to society as a whole

Production Externalities

When the social costs of production are different from the private costs of production. If social costs exceed private costs

Consumption Externalities

When the social costs of consumption are different from the private costs of consumption. If social benefits exceed private benefits, then there are positive consumption externalities. If social costs are more than private costs, then there are negative consumption externalities.

Public Good

A good which possesses the characteristics of non-rivalry and non-excludability

Private Good

A good which possesses the characteristics of rivalry (once consumed, it can not be consumed by anyone else) and excludability (it is possible to prevent someone else from consuming the good)

Free Rider Problem

When an individual or organisation receives benefits that others have paid for without making any contributions (no incentive to pay for it either)

Asymmetric Information

When buyers and sellers have different amounts of information, one group knows more than the other

Moral Hazard

When an economic agent makes a decision in their own best interest knowing that there are potential adverse risks, and that is problems result, the cost will be partly borne by other economic agents

Principal-agent problem

Occurs when the goals of principals, those standing to gain or lose from a decision, are different from agents, those making the decision on half of the principal. Examples include shareholders (principals) and managers (agents) or children (principals) and parents (agents)

Government Failure

Occurs when government intervention leads to a net welfare loss compared to the free market solution (a misallocation of resources as a result of government intervention)